Pension incomes set to shrink

Empty pockets

The amount of money people can earn from their pension annuity is set to fall sharply over the next year as a result of the economic downturn coupled with longer life expectancy.

For most of 2008 annuity rates have looked extremely competitive, actually hitting a six-year high earlier in the year. This trend has been driven by increased competition among insurers as well as attractive yields from corporate bonds, which are used to price annuity products.

However, according to annuity experts at Hargreaves Lansdown, the last few months have seen annuity rates fall back slightly with insurers less keen to pass on the full benefit of good corporate bond yields. Now, as the UK hovers on the brink of a recession, annuity rates are expected to experience a sharp fall.

Currently, a 65-year-old male can expect an annuity product paying 7.7% interest – by next year, a 65-year-old male is likely to earn less than 7% from his annuity.

Corporate bonds, as well as gilts, are used by insurers to fund annuities. The credit crunch has given the corporate bond sector a boost, with yields reaching unprecedented levels. However, the government’s banking bailout, designed to get institutions lending to each other again on the credit market, is expected to have a negative effect on bond yields, putting downward pressure on annuity rates.

Nigel Callaghan, pensions analyst at Hargreaves Lansdown, says: “In August it looked as though annuity rates may have come off the peak, with seven leading insurers reducing rates. The market mayhem during September and early October may have temporarily stopped the slide but widespread expectations still point to falling bond yields over coming months.”

The fact that inflation is believed to have peaked is also bad news for annuity rates. Lower inflation tends to reduce corporate bond yields, thus depleting the investment returns insurers use to pay annuity income.

In addition, increasing life expectancy is also putting pressure on annuity rates, as insurers are concerned about having to pay out for longer. Increasing numbers of providers are now offering enhanced annuity incomes to people with shorter life expectancies, such as smokers, and those who live in less affluent postcodes (where life expectancy is assumed to be shorter).

With just one pot of money to go round, the consequence of this is less competitive rates for the healthy and wealthy.

Callaghan adds: “Annuities are undergoing a rapid evolution towards an individual pricing approach where the actual rate is dependent on the investor’s health and lifestyle, as seen by the rise of enhanced and postcode annuities. This drags down rates for the healthy and those living in more affluent neighbourhoods.”

Both these factors will, in the medium to long-term, reduce the amount of income retirees can expect to earn from their pension pot.